A type of financial instrument called a reverse mortgage loan provides a lump sum, credit line, or monthly payments to borrowers. The loans are secured against a first mortgage deed on the home. Unlike traditional mortgage loans, current interest or principal payments are not required and the credit quality of the borrower, as measured, for example, by a Fair Isaac Corporation (FICO) score, is not relevant to underwriting of the loan. The loan is asset-based only, i.e., secured non-recourse against the property. Interest accrues and is compounded at the loan rate. As the debt balance grows, the loan to value (LTV) ratio typically increases over time, with the expectation that the last borrower will either move, die, or vacate the home for a period longer than 12 months before the LTV exceeds one, at which point the lender begins to suffer losses.
The reverse mortgage market is growing at over a 50% rate per annum as of 2007. The market is segmented into loans against homes with values less than approximately $400,000 and those above. For the former, borrowers are typically issued a Federal Housing Administration (FHA)—insured Home Equity Conversion Mortgage or HECM. As of 2007, the loan rate for HECM's was 150 basis points over the constant maturity one year treasury bill, which includes 50 basis points of FHA insurance which enables lenders to sell their loans to FHA upon the loans attaining a 98% LTV. For non-HECM or proprietary loans, the average rate as of 2007 was approximately three month London Inter-bank Offered Rate (LIBOR)+350 basis points. The amount of lump sum advance or credit line is determined by the principal limit factor or PLF. The PLF is a function of interest rates, assumed future housing appreciation (HPA), and the mortality, morbidity, and mobility (MMM) of the borrower or borrowers. The older the borrower, all else being equal, the higher the PLF and the greater amount of the proceeds that the borrower can receive. The greater the expected morbidity and mobility, all else being equal, the greater the amount of proceeds the borrower can receive. For the LIBOR+350 product, a 70 year old female who owns a house appraised at $1 million can expect to receive approximately $400,000 (as of 2007) in proceeds. The undrawn portion of the credit line increases with the loan rate in typical proprietary products although other growth rates may be used.
Unfortunately, the reverse mortgage market, as it is developing in the United States, suffers from a number of significant inefficiencies and consequences. As can be seen from the above description, the amount of proceeds (PLF) that can be advanced to a borrower is a function of his or her age (or a function of both ages in the case of a couple). The mortgage banking industry offering reverse mortgages uses the applicant's current age as a proxy for life expectancy. However, under federal non-discrimination laws applicable to the mortgage banking industry (i.e., credit transactions), a lender may not discriminate based upon applicant's gender or health status. Thus, the reverse mortgage industry must consider all single borrowers to be female or FESA, using the industry vernacular for “Female Equivalent Single Age.” As males have lower life expectancies than females, the use of FESA means that the mortgage banking industry provides reduced proceeds to males in an effort not to discriminate by applicant gender or providing too much proceeds to women by offering the male proceeds rate (if the industry adopted the “Male Equivalent Single Age” it would tend to increase proceeds to females).
Furthermore, current applicant age is a poor proxy for life expectancy. Otherwise, life insurance companies would not spend the enormous time and money they do underwriting each individual life insurance case. Every insured applicant who has taken out life insurance knows the time and inconvenience associated with the apparently simple process of obtaining life insurance. The underwriting process is meant to supply additional and statistically significant information about a person's expected lifespan. Underwriting in this manner should be common in the reverse mortgage industry. After all, a very sick 70 year old with reduced life expectancy should get more proceeds (higher PLF factor) than a healthy 70 year old. But again, anti-discrimination law prevents the practice of underwriting (presumably because it discriminates between the healthy and the sick).
By prohibiting common sense utilization of information such as gender, health status and other factors that can help determine life expectancy, the current regulatory environment quite severely limits the ability of the reverse mortgage industry to operate in the most efficient manner.
Reverse mortgage loans are distributed by mortgage bankers and mortgage brokers licensed and regulated under mortgage banking laws. Mortgage sales staffs are not in the practice of advising or establishing a lifelong relationship with a customer. Yet a reverse mortgage transaction, which is in essence a lifecycle transaction rather than a discrete asset financing, beckons for an enduring relationship with the customer. Typically, those involved in lifecycle financial planning are certified financial planners and life insurance agents. Yet, because of mortgage banking regulation at the state and federal level, it is nearly impossible for these professionals to be paid for making a referral or providing transaction flow to mortgage bankers and brokers offering reverse mortgage products. As such, because of regulatory barriers, there is a great difficulty in providing efficient and adequate services and products to the reverse mortgage customer.
Furthermore, the primary use of reverse mortgage proceeds by borrowers is to purchase necessities such as long term care, Medicare part D coverage, lifetime income in the form of immediate or deferred annuitization or longevity insurance, and others necessities. However, life and health insurance providers who sell these products and services are licensed and regulated under state insurance laws and are rarely licensed to sell reverse mortgages. Thus, as long as reverse mortgages and the products and services purchased with reverse mortgage proceeds are regulated under different regimes and offered by different industries, there will be inefficiencies in their distribution.
Reverse mortgages suffer from two types of inefficiencies. First, for the lender, the reverse mortgage loan, which pays no current interest, is an Original Issue Discount (OID) instrument. As such, the lender or loan owner pays tax currently at full ordinary income rates (assuming a taxable investor) even though no income is actually received. A simple example follows: 1) Value of home: $1,000,000; 2) Age of borrower: 70; 3) PLF: 40%; 4) Proceeds: $400,000 (PLF*Home Value); 5) Loan Rate: LIBOR+350 basis points; and LIBOR: 5.5%.
In this example, the loan accrues at 9% (LIBOR at 5.5%+margin of 3.5%) and no interest is currently paid by the borrower. However, the lender or the owner of the loan must pay ordinary income tax on the accruing interest under the Original Issue Discount (OID) rules under the Internal Revenue Code (26 USC sections 1271-1275). For example, assume the lender pays tax at a federal tax rate of 35%. Each year the lender is taxed on the 9% accrual and must pay 3.15% or 35% of the coupon as tax even though no income is received. Strikingly, even though the lender must pay tax currently, the borrower does not receive an offsetting deduction. This is because debt against personal use property is not considered eligible for deductions under the rules for cash basis taxpayers (almost all homeowners are cash basis taxpayers). The gross asymmetry of taxation makes reverse mortgages more expensive to provide. To make matters worse, a reverse mortgage is typically taken out by a borrower who has lived in his current home for some time. Reverse mortgage deductibility is therefore limited to the interest that accrues on only $100,000 of the loan (as with home equity loans). The few reverse mortgage loans that are used in original acquisitions of homes may qualify for the full deductibility of interest on up to $1,000,000 of debt. Thus, the typical tax scenario is that the lender pays full ordinary tax on a current basis without receiving income and the borrower deducts a small portion of the interest on a deferred basis when the loan is eventually paid.
Reverse mortgages are inefficient for another reason. If the reverse mortgage debt balance exceeds the value of the home, and the loan becomes due or is repaid (e.g., borrower dies or moves), the borrower can incur substantial capital gains tax under the principal of debt forgiveness as the following two examples illustrate based on the following assumptions: 1) Borrower's basis in home: $100,000; 2) Home's current value: $1,000,000; 3) Reverse mortgage proceeds: $400,000; 4) Reverse mortgage not original acquisition indebtedness; 5) Tax Code section 121 requirements met; and 6) At death of Borrower: Outstanding loan balance is $2,000,000 and FMV of home is $1,000,000.
Example 1: If borrower is sole owner of property and dies before Dec. 31, 2009 or after Jan. 1, 2011 and a sale of the home takes place where debt balance greater than FMV, the following is the tax consequence: 1) Basis of property: step-up in basis to $1,000,000; 2) Gain: $1,000,000 (equal to debt balance of $2,000,000 minus $1,000,000 FMV); 3) Home equity deductions: $400,000 (accrued interest on $100,000 of the $400,000 mortgage); 4) Taxable Gain: $600,000; 5) Federal Tax: $90,000 (15% capital gains rate on Taxable Gain); and 6) Who pays tax: a) If borrower left a will, the Executor pays out of estate assets; b) If borrower bequeathed property to individual, the individual is liable and should consider disclaiming his interest; and c) If borrower died intestate, Administrator pays out of estate assets.
A less likely scenario is the surviving spouse moving out of the home (e.g., into a nursing home) as follows: First spouse dies after Jan. 1, 2011 and surviving spouse moves into nursing home or otherwise leaves home: 1) Basis in property stepped up partially to $550,000; 2) Gain on sale: $1,450,000 ($2,000,000 debt balance-$550,000); 3) Home equity deductions: $400,000; 4) Tax code section 121 Exclusion to surviving spouse: $500,000, if sale is in year of first spouse's death and joint return is filed; $250,000, if sale is in a year after year of first spouse's death or if joint return is not filed; 5) Taxable gain assuming sale more than a year after first spouse death: Taxable Gain: $1,450,000-$400,000-$250,000=$800,000; and 6) Federal Tax: $120,000 (15% capital gains rate on Taxable Gain).
As can be seen from this example, a reverse mortgage is hardly a “heads the borrower wins, tails the lender loses” proposition due to the debt forgiveness taxation upon sale of the home when the debt balance exceeds the home value.
The reverse mortgage industry is in a nascent state and is generally unsophisticated in tax matters. No loans have yet produced the above results due to how young the industry is. But given enough time, many existing loans will produce these adverse outcomes and borrowers will suffer financially. Lenders may also face legal and regulatory action by not disclosing these possible adverse outcomes to borrowers.
Another type of financial instrument has emerged in France called “viager” whereby a buyer can purchase the remainder interest of a homeowner. This provides the homeowner with liquidity linked to his home ownership and can achieve similar financial goals of a reverse mortgage. In the viager, the buyer of the remainder interest owns the home when the homeowner/seller dies.
However, there are many problems with the viager. First, should the homeowner/seller die shortly after completion of the viager sale, the buyer obtains a beneficial windfall. Such buyer benefit linked to the early death of the homeowner seems manifestly unfair. Further, it is not unlikely that courts and legislatures would act to regulate the viager in a manner similar to the “insurable interest” requirement for life insurance to prevent such perverse incentives.
Second, the viager is a one-off, inflexible instrument because it cannot be unwound. As such, it is particularly inappropriate for United States homeowners who have very high mobility, particularly homeowners in their 60's (approximately 8-10% per annum).
Third, the viager does not allow for flexible payments because it typically comprises an upfront component (the “bouquet”) followed by lifetime annuity payments.